On December 30, 2009, the Securities and Exchange Commission (the “SEC”) published amendments to Rule 206(4)-2, commonly called the “Custody Rule”, under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). As detailed in the adopting release, the amendments were adopted in response to various scandals and enforcement actions in the investment industry in an effort to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities. While the new amendments largely implement changes proposed by the SEC in May 2009, the SEC made several notable changes to the original proposal in response to comments it received. We have prepared this Legal Alert to provide an overview of the key amendments.
In general, the amended Custody Rule retains the core requirements of the current Custody Rule. Advisers with custody of client assets are generally required to: (i) maintain client funds or securities with a “qualified custodian” (e.g., a registered broker-dealer or bank), (ii) if the adviser opens a custody account for the client, provide clients notice of the name and address of the qualified custodian (the “Custodian Notice”), and (iii) have a reasonable belief that clients receive account statements at least quarterly. The account statements may be sent by the qualified custodian or the adviser; however, if the adviser sends the account statements, then the adviser is required to engage an independent public accountant at least annually to verify the client assets in a surprise examination. The current Custody Rule also provides that advisers with custody of pooled investment vehicles may satisfy the requirements to deliver statements by obtaining an annual audit of the pool that is mailed to investors within 120 days of the end of the fiscal year.
Elimination of Adviser Delivery Option. As noted above, under the current Custody Rule, an adviser with custody of client funds or securities may deliver account statements in lieu of the qualified custodian if the adviser undergoes a surprise examination by an independent public accountant at least annually. The amended Custody Rule eliminates this option, and requires in all cases that the adviser have a reasonable belief, after due inquiry, that the qualified custodian sends account statements directly to the client at least quarterly. While “due inquiry” is not defined in the Custody Rule, the SEC suggests in the Adopting Release that receipt of a copy of the account statement delivered to clients would satisfy the due inquiry requirement.
New Legend Requirement. While the amended Custody Rule eliminates the option for advisers with custody to send account statements in lieu of statements from the client’s qualified custodian, it does not prohibit advisers from sending their own account statements in addition to the statements from the qualified custodian. However, if an adviser that is required to send a Custodian Notice sends such statements, the adviser is required under the amended Custody Rule to include a legend with the Custodian Notice and all subsequent statements sent by the adviser that urges the client to compare the adviser’s statements with the statements sent by the custodian.
Reinstatement and Modernization of the Surprise Examination Requirement. One of the most controversial provisions of the proposed amendments to the Custody Rule was the reinstatement of the general requirement that advisers with custody undergo a surprise examination from an independent public accountant at least annually. While commenters generally did not object to the utility of these surprise examinations, they expressed considerable concern about the potential costs, particularly for small advisers and advisers who only have custody due to fee deduction. The amended Custody Rule adopts the general requirement that advisers with custody undergo surprise examinations as proposed; however, the amended Custody Rule carved out several key exceptions:
- advisers with custody solely due to the authority to withdraw funds from client accounts for their advisory fees are not subject to the surprise examination requirement;
- advisers to pooled investment vehicles that (i) obtain annual audits from an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB); and (ii) deliver such audits to investors within prescribed time periods (120 days after fiscal year end for most pools and 180 days for funds of funds) are not subject to the surprise examination requirement.
The amended Custody Rule also includes new requirements for the surprise examination intended to modernize these reviews. Under the amended Custody Rule, advisers subject to the surprise examination requirement would need to enter into a written agreement with an independent public accountant that requires, among other things, that:
- the accountant notify the SEC within one business day of finding any material discrepancy during the examination;
- within 120 days of the exam, the accountant submit a Form ADV-E to the SEC accompanied by the accountant’s certificate reporting on the nature and extent of the exam; and
- within four business days of its resignation or dismissal, the accountant file a statement regarding the termination with its Form ADV-E.
Privately Offered Securities; Companion Accounting Release. Under the amended Custody Rule, privately offered securities owned by clients and held in the custody of an investment adviser will be subject to the same annual surprise examination requirements as publicly-traded securities. In response to commenters’ requests, the SEC is providing guidance regarding the procedures that an accountant should undertake with respect to the surprise examination of privately offered securities in a companion release entitled Commission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act of 1940, Release No. IA-2969 (December 30, 2009) (the “Accounting Release”). The Accounting Release also provides general guidance regarding the relevant auditing and attestation standards that apply to surprise examinations, procedures that accountants should employ, and the required internal control report and its relationship to the examination.
Control by Related Persons. The amended Custody Rule also imposes additional requirements for advisers with client assets maintained by the adviser itself or one of its related persons, rather than with an independent qualified custodian. In these cases, the adviser will be subject to the following requirements in addition to the annual surprise examination:
- an adviser must obtain, or receive from its related person, a written report at least annually that includes an opinion from an independent public accountant regarding the adviser’s or related person’s internal controls (e.g., a Type II SAS 70 internal control report);
- the accountant issuing the internal control report, as well as the accountant performing the surprise examination, must be registered with, and be subject to regular inspection by, the PCAOB; and
- the adviser must maintain the internal control report in its records and make it available to the SEC staff upon request.
Additional Requirements Applying to Advisers to Pooled Investment Vehicles. As noted above, advisers with custody over assets of pooled investment vehicles may generally avoid the surprise examination requirement by obtaining an audit from a PCAOB audit firm and distributing the results of the audit to investors within prescribed time limits. However, the amended Custody Rule imposes the following additional requirements on advisers to pooled investment vehicles:
- as with ordinary accounts, if assets of a pooled investment vehicle are maintained with the adviser or a related person, then the pool would have to obtain, or receive from the related person, an internal control report;
- advisers to pools that distribute audited financial statements to comply with the Custody Rule must obtain an audit upon liquidation of the pool when the liquidation occurs prior to the pool’s year end, and distribute the results to investors; and
- advisers to pools whose only investors are other pools related to the adviser will not meet the requirements of the Custody Rule by sending an account statement only to the investor pool; rather, these advisers will have to obtain and distribute audited financial statements or account statements of the upper tier pools to the indirect beneficial owners, or consider the assets of such pools within the scope of the underlying pooled investment vehicle’s financial statement audit or surprise examination.
Compliance Policies and Procedures. The Adopting Release provides guidance to advisers regarding the types of policies and procedures they should adopt to satisfy their obligations under Rule 206(4)-7 with respect to the Custody Rule. Among other things, the recommendations include conducting background and credit checks on employees who can access client assets, requiring authorization by more than one employee to move funds from client accounts, limiting the number of employees interacting with client custodians and rotating them periodically, and, if the adviser also serves as qualified custodian, segregating the duties of advisory and custodial personnel.
Amendments to Form ADV. In order to coordinate the disclosures in Form ADV with the amended Custody Rule, the SEC also adopted the following changes to Form ADV:
- Item 7 of Part 1A is revised to require the reporting of all related persons who are broker-dealers and identify which, if any, serve as qualified custodians with respect to the adviser’s clients;
- Item 9 of Part 1A is revised to require reporting of (i) the total number of clients and amount of client assets in the adviser’s (or a related person’s) custody; (ii) if the adviser, or a related person, acts as an adviser to a pooled investment vehicle, whether the pool is audited and whether the qualified custodians send account statements to investors; (iii) whether an independent public accountant conducts an annual surprise examination; (iv) whether an independent public accountant prepares an internal control report for the adviser or a related person; and (v) whether the adviser or a related person serves as qualified custodian for the adviser’s clients; and
- Schedule D of Form ADV is revised to require that advisers (i) identify and provide certain information about the accountants that perform audits and surprise examinations and that prepare internal control reports; (ii) identify related persons that serve as qualified custodians for client funds or securities not otherwise disclosed in Item 7; and (iii) where the adviser has a related person with custody, whether the adviser has determined that it has overcome the presumption that it is not operationally independent from that custodian and thus not subject to the surprise examination requirement.
The Custody Rule amendments adopted on December 30, 2009 are effective 60 days after their publication in the Federal Register. Compliance with the amended Custody Rule is not required until March 12, 2010.